What 2025 Taught Us About the Importance of Diversification

Key takeaways

• Market leadership broadened with Small Caps in 2025, while cyclical sectors and international equities also gained traction.
• Amid market uncertainties and a softening rate outlook, fixed income saw renewed interest as part of risk diversification.
• 2026 will bring a renewed focus on diversification and diversifying beyond concentrated indices and sectors.

The S&P 500 surged in 2023 and 2024, with returns of 26 percent and 25 percent, respectively. The two-year rally, propelled by strong earnings from the “Magnificent Seven” tech stocks and the artificial intelligence (AI) boom, led many investors to question the merits of investing in anything other than Large-Cap stocks at the end of 2024.

Asset classes like international developed and emerging market stocks, which had been on a run of relative underperformance for a number of years, were shunned. After all, why invest in anything else given that U.S. equities had been a top-performing asset class for at least the last 15 years?

Last year’s volatile market provided some answers to this question. While 2025 brought some periods of concentrated outperformance, overall asset class performance broadened out as macro conditions shifted from previous years. Equity markets digested the final stages of tight monetary policy, moderating inflation and a weaker dollar, with the economic environment proving more resilient than many had expected.

The S&P 500 still had a good run in 2025, ending the year up nearly 16 percent, its third consecutive year of double-digit growth. As we have consistently noted, however, this performance continued to be driven by a narrow group of stocks largely tied to the AI theme, with a historically low 29 percent of S&P stocks beating the index return in 2023, 28 percent in 2024 and 31 percent in 2025.

The aforementioned international developed and emerging-market asset classes—left for dead at the end of 2024—led the way in 2025 with both nearly doubling the return of the S&P 500, buoyed by a weaker dollar. In fact, a diversified mix of asset classes outperformed the stand-alone S&P 500 because of the strong returns in international and emerging-market stocks. And importantly, the diversified portfolio experienced less volatility. In short, diversification worked in 2025.

Each year, we update our asset allocation “quilt” (see the graphic below) to help visualize our own diversified, long-term investment strategy. By illustrating the performance of the nine asset classes we use to build our well-diversified portfolios, we can observe the swings in performance from year to year. That unpredictable nature of market performance, whether year to year or over time, is exactly what a diversified portfolio is built to weather.

The Importance of Diversification

Maintaining a diversified portfolio has proved its value over the last year. Portfolios that were concentrated in a handful of U.S. sectors or overly reliant on a single policy outcome absorbed the deepest losses during the April volatility. In contrast, portfolios with meaningful exposure to international equities and high-quality bonds experienced less severe drawdowns and recovered more steadily.

Diversification does not eliminate risk, especially during systemic events, but it reduces the severity of shocks by distributing risk across exposures that respond differently to macro catalysts. For investors focused on long-term outcomes, spreading risk across regions, asset classes and economic exposures remains one of the most reliable ways to navigate unpredictable markets and preserve the potential for steady compounding over time.

From volatility surrounding 2025’s “Liberation Day” to the government shutdown in the fall, 2025 proved the importance of maintaining a forward-looking, well-balanced portfolio, even in the face of widespread uncertainty. As we enter 2026, diversification and adherence to a financial plan can help navigate any potential uncertainty. Keep this asset class performance chart in mind as a reminder to stay diversified, whatever the future holds.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.

Compounded returns are measured by the geometric mean of a given portfolio, which takes into account the sequence of returns over a given period of time and more accurately shows the portfolio’s performance over that period of time as compared to a simple average.

Risk is represented by standard deviation, which is the measure of total volatility in a portfolio. It shows how widely a portfolio’s returns have varied around the average over a period of time. Standard deviations on this chart were calculated using monthly returns.

Sources for asset class chart:

U.S. Large Cap: The S&P 500^® Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

U.S. Mid-Cap: The S&P Mid Cap 400^® Index measures the performance of 400 mid-sized companies in the U.S., reflecting this market segment’s distinctive risk and return characteristics.

U.S. Small Cap: The S&P Small Cap 600^® Index is a market-value-weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation.

International Developed: The MSCI EAFE^® Index Net Total Return measures the equity market performance of developed markets (markets domiciled in high-income countries, as defined by the World Bank, that most investors consider having a well-developed operating and regulatory structure for its capital markets), excluding the U.S. & Canada. The index returns are calculated with reinvestment of net dividends after the deduction of applicable non-resident local withholding taxes.

International Emerging: The MSCI Emerging Markets^® Index Net Total Return measures the equity market performance of emerging markets (markets domiciled in lower-income countries, as defined by the World Bank, that are experiencing rapidly developing economies). The index returns are calculated with reinvestment of net gross dividends after the deduction of applicable non-resident withholding taxes.

Real Estate: The Dow Jones U.S. Select REIT Index is composed of companies whose charters are the equity ownership and operation of commercial real estate and that operate under the REIT Act of 1960. Each REIT in the REIT Index is weighted by its float-adjusted market capitalization. The total return version of the index is calculated with gross dividends reinvested.

Commodities: The Bloomberg Commodity Index (BCOM) is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.

Fixed Income: The Bloomberg U.S. Aggregate Index measures the performance of investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS. It rolls up into other Bloomberg flagship indices.

Cash Alternatives: Cash alternatives are represented by the FTSE 3-Month Treasury Bill Index with income reinvested, representative of the three-month Treasury bills.

Diversified Portfolio: A portfolio of all segments disclosed above, with the following weightings: 23% U.S. Large Cap; 6% U.S. Mid Cap; 3% U.S. Small Cap; 13% Int’l Developed; 6% Int’l Emerging; 4% Real Estate; 5% Commodities; 38% Fixed Income; 2% Cash Alternatives.